Too Big to Fail

Story Highlights:

• It is expected Bernanke will address the expanding role of central banks and speak to the notion of "too big to fail" at the Fed's symposium on August 22.
• These are challenges for the Fed, but its actions thus far seem appropriate given how institutions do business today.

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When the Fed stepped in to ease the sale of troubled Bear Stearns to JP Morgan, folks called it a bailout. When the solvency of Freddie and Fannie was called into question, again the Fed stepped in to offer liquidity assistance. Yet, in the course of the past year's financial turmoil, we've also seen regional bank IndyMac and other smaller institutions fail. Why help Bear? Why support Fannie? Why not "bailout" IndyMac? Some folks have interpreted Fed actions (both today and over the decades) to mean some institutions are "too big to fail."

Yet, others gripe no clear "too big" distinction exists, and there's widespread anticipation Bernanke may finally address this issue at the Fed's symposium on August 22.

Bernanke Tries to Define What Institutions Fed Could Let Fail
By Craig Torres, Bloomberg

Will he? Won't he? Bernanke may throw down some guidelines, or he may demure from drawing a hard and fast line.

But instead of arguing what's "too big," perhaps we should argue whether we need a distinction at all. After all, what exactly determines if an institution is too big, or not big enough? What if we draw a line, and later deem it appropriate to save someone smaller, but not someone bigger? How do you make that call? Or, how do you know if you stepped too far in the direction of protecting markets that you are actually harming markets? Thus far, the Fed seems more interested in supporting assets significant to the normal functioning of markets than pinpointing selected institutions—which seems a fair enough distinction to make.

Any definition of "too big" would likely be the subjective interpretation of a financial regulator and vulnerable to a slippery slope of revisions and adjustments—especially as institutions grow in size and scope as they've done throughout the years. (Banks deemed "too big to fail" in the 1980s would, largely, be dwarfed by many institutions today. Does that mean in retrospect they weren't too big to fail after all?)

Nonetheless, the expansion of the Fed's role as creditor and capital markets regulator, as with any government power, certainly could to lead to negative consequences. Has its actions been appropriate for the way institutions do business today? Thus far, it seems like it. Could it get out of hand? Sure. Should we be vigilant? You bet. Are we lost down some path of moral hazard because some institutions have chosen to avail themselves of newly available credit from the Fed? Doesn't seem like it. And remember, "credit" implies a repayment down the line. Perhaps the reason why borrowing from Fed auctions is consistently not at full capacity is because institutions realize this—and choose for themselves whether borrowing is appropriate or not. And the choice of many is much better for markets than the choice of one.